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It is a well-known fact that a key source of the financial crisis
from which we still suffer was something called CDOs −
collateralized debt obligations, which were packages of loans,
mostly home mortgages, that were sold to various financial
institutions. As a consequence, the ultimate holders of these
debts were institutions that really knew almost nothing about
them. When the economy turned down, many more of the debts went
bad than anticipated, thus causing many financial institutions to
fail, which exacerbated the downturn and turned an ordinary
recession into the worst since the Great Depression.

Once upon a time, when a bank loaned someone money to buy a
house, it held that mortgage until it was paid off. Thus the bank
had a strong incentive to make sure that the borrower was
credit-worthy. And in those days that wasn’t so hard, because
banks normally lent only to individuals and businesses in its
immediate vicinity with whom it probably had done business for
many years. The banks knew very well who was a good credit risk
and who wasn’t.

The problem was that a local bank with limited deposits only had
so much money to lend. This made it hard even for those with good
incomes and credit to get mortgages. Until the 1930s, mortgages
were uncommon and people mostly paid cash when they bought a
house, which obviously limited the potential for homeownership.
The homeownership rate was well below 50 percent until after
World War II, according to the Census Bureau.

But in the 1930s, the federal government began setting up
agencies such as the Federal National Mortgage Association −
popularly known as Fannie Mae − that would buy mortgages from
local banks, thus replenishing the funds available to lend to
other home buyers. This greatly increased liquidity in the
housing market and helped fuel a vast expansion of homeownership
after the war as people moved out of rental apartments in the
cities in favor of houses in the suburbs. The homeownership rate
jumped from 44 percent in 1940 to 55 percent in 1950 and 62
percent in 1960.

As mortgages became tradable, there was an important need for
somebody to look through the CDOs and assess the risk of default.
Financial institutions turned to the three principal credit
rating agencies, Moody’s, Standard and Poor’s, and Fitch, which
had long been in the business of rating corporate bonds with
letter grades: AAA for those with the lowest risk of default, BBB
for those with a medium risk and so on.

But the credit agencies were less well adept at judging the
creditworthiness of CDOs than everyone, including the Securities
and Exchange Commission, thought, which contributed to a bubble
in the housing market as investors eagerly bought CDOs that they
thought were virtually riskless. This pumped vast sums into the
housing market so that more CDOs could be created to satisfy
investor demand, which led to a decline in lending standards that
the rating agencies failed to pick up until it was too late. As
New York University economist Lawrence J. White explains:

Favorable ratings from these three credit agencies were crucial
for the successful sale of the [CDO] securities based on subprime
residential mortgages and other debt obligations. The sales of
these bonds, in turn, were an important underpinning for the
financing of the self-reinforcing price-bubble in the U.S.
housing market. When house prices ceased rising in mid 2006 and
then began to decline, the default rates on the mortgages
underlying these securities rose sharply, and those initial
ratings proved to be excessively optimistic. The price declines
and uncertainty surrounding these widely-held securities then
helped to turn a drop in housing prices into a widespread crisis
in the U.S. and global financial systems.

Another problem is that certain biases had crept into the credit
rating business dating from the 1930s, when the SEC essentially
gave the force of law to credit ratings by decreeing that banks
could not buy bonds with a rating less than BBB. Moreover, the
SEC said that the only acceptable ratings were from “recognized”
rating agencies, of which there were only four. (At the time,
Standard and Poor’s were two different companies; they merged in
1941.) Thus the SEC created a de facto cartel that continues to
operate to the present day.

Moreover, because the methodology used by the credit rating
agencies was proprietary and critical to their business, they
were not forced to divulge it, creating a lack of transparency.
Thus we had a situation in which there was little competition
among the rating agencies because new entrants were effectively
prohibited, and the agencies weren’t required to divulge the
methods they used to determine creditworthiness. As a
consequence, there was no self-correcting market mechanism that
would ensure accuracy in credit ratings and prevent the
introduction of biases that tended to push ratings above the
SEC-mandated threshold for “investment grade” securities. (See
the fascinating new paper by economists David M. Levy and Sandra
J. Peart.)

A final problem emerged when the credit rating agencies changed
their business model. Historically, investors had paid them for
their ratings, which helped ensure accuracy. If an agency was
wrong too often then customers would buy ratings from one of its
competitors instead. But in the early 1970s, all the agencies
switched to a model in which the bond issuer paid for the rating.
This created an enormous conflict of interest because the issuer
always wants the best rating possible and can take its business
elsewhere if it doesn’t get the rating it wants.

For many years, tradition and concerns about their reputations
prevented too much upward bias from creeping into the bond
ratings. But as time went by, pressure to maximize earnings led
to slippage in the quality of ratings. This became obvious to
everyone in 2001 when Enron declared bankruptcy. All three credit
rating agencies had its bonds rated as investment grade until
literally days before the company went under. This led the SEC to
conduct an extensive study that finally recognized some of the
structural problems in the credit rating industry.

However, problems in the industry persisted and even got worse
after CDOs were created. One reason noted by Prof. White is that
securities rated AA or better qualified for a lower capital
requirement. Normally, banks are required to have capital equal
to 4 percent of the value of mortgages held. But those with an
implicit government guarantee, such as securities issued by
Fannie Mae, only required capital equal to 1.6 percent of asset
value. Once AA rated CDOs qualified for the same lower capital
requirement that applied to quasi-government securities, it put
even more pressure on the credit rating agencies to inflate
ratings. That would free up bank capital for additional
profit-making investments.

Issuers also began creating new securities designed to game the
rating system and effectively disguise their risk. The methods
used were so complex that they were virtually unintelligible even
to the rating agencies. But under enormous financial pressure to
rubber stamp highly profitable CDOs with an investment grade
rating, the agencies went along for the ride.

Vivid evidence of the failure of the credit rating agencies to do
their job was presented to the Financial Crisis Inquiry Commission on Sept.
23. D. Keith Johnson, who held high-level positions in the
banking industry throughout the 2000s, testified that he was rebuffed by the rating
agencies when he personally informed them of problems he had
identified in the quality of many mortgages being bundled into
CDOs.

As early as 2001, University of San Diego law professor Frank Partnoy identified many of the problems
with credit rating agencies that subsequently fueled the housing
bubble. Yet even after those problems heavily contributed to the
second greatest economic crisis in American history, little has
changed. In fact, the agencies are growing in importance because
of their role in rating sovereign debt – bonds issued by national
governments. A Sept. 29 report from the International Monetary
Fund warns that some of the practices of the rating agencies
may exacerbate debt problems.

The problems of the credit rating agencies point once again to
the great value of information and the dangers of institutional
biases. There’s no obvious solution; the best that can probably
be done is to foster greater competition and transparency in the
rating business. Perhaps the best advice is caveat emptor – let
the buyers of securities beware those that are so opaque that
their risks cannot assessed within a reasonable margin of error.